By NEAS - 11/22/2022 5:17:33 PM
● With all-equity financing, a firm’s opportunity cost of capital is 11.80%.
● The firm refinances to a debt-to-value ratio (D/V) of 45%, at a cost of debt capital rD of 8.60%.
● The corporate tax rate is 27%.
Question 8.1: Cost of equity capital rE after refinancing
What is the firm’s cost of equity capital rE after the refinancing?
Answer 8.1: If the corporate tax rate is zero, the capital structure does not affect the weighted average cost of capital, which equals the opportunity cost of capital with all-equity financing, which is
the debt-to-value ratio (D/V) × the cost of debt capital rD × (1 – the corporate tax rate)
+ the equity-to-value ratio (E/V) × the cost of equity capital rE
For the figures in this practice exam question:
rE × (1 – 45%) + 45% × 8.60% = 11.80%
➾ rE = (11.80% – 45% × 8.60%) / (1 – 45%) = 14.42%
Question 8.2: Weighted average cost of capital after refinancing
What is the firm’s weighted average cost of capital (WACC) after the refinancing?
A. 10.76%
B. 11.29%
C. 11.83%
D. 12.37%
E. 12.91%
Answer 8.2: For the weighted average cost of capital, we include the corporate tax rate of 27%:
WACC = (45% × 8.60%) × (1 – 27%) + (1 – 45%) × 14.42% = 10.76%
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